"Downwards is the only way forward"

The past couple of years have been the hardest of my personal and professional life. This newsletter will be the start of a new chapter. It will be a monthly newsletter with intermittent market updates when the occasion occurs.

Any market or trading views are purely my own thoughts and views and in no way are to be considered investment advice.

Let’s kick things off.

“This time it’s different” - perhaps, or maybe we have just forgotten old lessons.

Heading into 2023 has been very different backdrop than the what we are used to for most of this century. The main reason for this is inflation and the world walking back from globalisation. Therefore, some assumptions that have held strong for the past decade or longer are not applicable.

However, I do not subscribe to either extreme of the market. I do think inflation is going to be persistently higher than what we were used to. I also do think we will go through cyclical periods of deflation as year-on-year base effects run their course and demand gets choked off. We will then see fiscal support steady the ship, and inflation return.

What has changed is that the default position of central banks is to be hawkish and err on the side caution before cutting. This provides a different investment backdrop.

On the flipside, whilst central banks are more hawkish, the governments the world over have a taste for fiscal spending and the (electoral) benefit of this type of support.

So instead of a world of cheap money with governments trying to be austere (looking at you UK and Europe) we now have a world where:

As Jeff Currie said “ the lower incomes population cause inflation”. Whilst I disagree with his wording, the point he is trying to make translates to how stimulus to lower income earners impacts demand for goods and commodities.

We are heading into the “upside down” No longer austerity from the fiscal side and zero rates, but fiscal largess and higher interest rates. This has severe implications for asset prices and investment mental models.

A scene from Stranger Things - © Netflix

In 2021 I wrote about the 6 forces of inflation that former RBA Governer Macfarlane outlined and their modern day iterations.

“The six forces, in Macfarlane’s view, related to the period from the of the mid 1960’s to the end of the 1970’s:

Nearly two years later we can see that inflation has persisted and its source comes from a variety of factors. However, this piece is not about inflation, it is about the opportunity that lies ahead.

Today we seem to be at a crucial juncture in commodity markets. Thanks to higher prices, demand for most commodities has slowed vs. 2022. However, since the lows of the stock market in late October there has been a lot dispersion in performance. Iron Ore is up nearly 60%, energy is down 20% whilst most other markets are up 5-15%. This chart shows the Bloomberg Commodity Indices for Energy, Agriculture, Softs and Industrial Metals as well as the COMEX Copper price, gold price and the Aussie dollar.

A great example of this impact is in the oil market, which despite many doomsdayers calling for $200 oil, now sits below $70 for WTI.

Daily Chart - 2nd Contract

N.B. I did start writing this note earlier in the month and was anticipating $70 to hold for a period before collapsing in Q2 as the China boost fades. However, growth scares post the collapse of SIVB have fast forwarded this move.

The reasons for expecting support at $70 were clear:

However, now that prices are really starting to break down where are we left? Calendar spreads remain weak in crude. Until they start to show some signs of life I would be staying structurally bearish, but being conscious that positioning is likely to be short (or a lot less long) after the price action of the past two weeks. Brent spreads show this weakness very well.

Below are some spread charts courtesy of Macquarie for both major crude oil futures markets. I think they tell the story well. Supplies are building and demand continues to disappoint.

We are still waiting an up to date CFTC Report to more accurately report on positioning. I will come back to that in a future report.

Iron Ore is the stand out performer over the past 5 months. despite mixed supply side Dfundamentals. Demand from China is expected to be strong heading in Q2 of this year and the market.

The strength of the rally looked in question as calendar spreads remained in a mild backwardation. Through this month, the backwardation has increased suggesting nearby demand is good. Or is just speculation? In the face of the moves in crude and macro the strength in China is not to be ignored.

Comex Copper has all been about flat price. With prices declining rapidly over the past few weeks. We are now holding around the 100-day moving average.

The curve structure has not changed much, just a general adjustment lower down the line.

Inventories in China are decreasing but not yet critical. (source Macquarie)

This all leaves me with no strong view. Macro is not positive, fundamentals in China mixed and general stock levels on the lower side to normal.

Given this macro commodity backdrop it is hard to be bullish markets from a flow perspective.

Whilst everyone likes to see a definitive view to then pin some accountability to I think the amount of uncertainty out there presently warrants caution. What is certain is that volatility across asset classes will remain high and this provides trading opportunities in either direction depending on your risk appetite and time frame. However, I can’t help feeling that the pain of higher rates is only now starting to flow through the real economy. Whilst central banks try and hold rates as high and for as long as they, this means asset prices are like to be lower over the balance of the year, “Downwards is the only way forwards” as Cobb would say.

As the noise of SIVB is put behind us and the impact that has on the hawkishness of central banks and the real economy, I think it is best to play it safe to. Stay long nearby government bonds (1-3 years) , long iron ore structure (2H 23 vs Cal 24), short crude oil structure (3-9 months tenors) and be patient for opportunities.